The 401k Layoff Trap

I was surprised at the "Borrow from your 401k" suggestion. While it's true that it's better than cashing out, so many people are being laid off unexpectedly. When this happens, it must all be paid back or considered a cash-out, which comes at a time when people are least able to repay because they just lost their job. It should at least have been mentioned as a consideration. -- Deborah in San Diego

Deborah makes a very interesting point. She's referring to an article entitled "Need Cash" that discusses 10 ways to raise cash quickly if you're in a jam.

How widespread is the problem? It's hard to find many statistics on 401k loans. But a Harvard report cites two statistics that point to trouble. The vast majority of plans allow for borrowing (over 85% in 2005, Investment Company Institute, 2006). And they also report that 18% of 401(k) participants had a 401(k) loan in 2006.

We can't know for sure, but it's probably not an unreasonable guess that about one in five or six people who are laid off will have a 401k loan outstanding when they get the pink slip.

And, that's when Deborah's problem comes in. As a general rule, if you leave your employer you need to repay the 401k loan in full. You may be given a month or so, but that's it.

Any amounts that you fail to repay are treated like a withdrawal. That means that you add the amount of the loan to your income and you'll pay normal income taxes on it. Plus, you'll be liable for a penalty that equals 10% of the unpaid loan.

What can you do about it? First, if you have a 401k loan and think that you could lose your job, you need to take it seriously. Begin by estimating how much the taxes and penalties would cost you if you didn't repay part or all of the loan. It'll be bad. But since your income will be lower than previous years (because of the layoff), your tax rate should drop (that assumes no tax rate hikes).

In any event, you need to have some idea of how much the penalties and taxes are. You'll want to compare that to the cost of other alternatives.

There are a couple of withdrawal exceptions that might help in a layoff situation:

You were age 55 or over and you retired or left your job

You paid for medical expenses exceeding 7.5% of your adjusted gross income

What if you don't fit into one of those categories? Your options are limited, but you still have some choices to make.

Now might be the time to consider selling a car. Your ride needs to be worth more than any loans on it. Any cash you raise could help pay off the 401k loan. If you're not working transportation won't be such a big issue. You can always buy another car when you're employed again.

Do you have a homeowner's line of credit or enough equity to refinance your home? That could provide some money to repay the 401k loan. Refinancing will be easier before you lose your job. So you might want to consider this if you expect to be laid off.

Using your credit card to pay off the 401k loan is a high-risk strategy. You'll probably pay a higher interest rate. And, you'll also need to keep making payments even if your income has dried up. Plus, you'll be consuming part of your credit line that you may need later.

The only advantage to shifting the debt to a credit card is that you avoid the tax problems of a 401k withdrawal. But it's wise to compare the numbers before you make a decision.

The unfortunate fact is that most 401k loans were promoted as an painless way to 'borrow from yourself'. Turns out that's not so true if times get tough.

Comments

un employment go to the office and apply thats what its for or go online to apply for it just leave the 401k if you take out before 59 1/2 you will be stiffed by the IRS for a penalty and aways have 6 months to one year of saving in case of the layoff but leave the 401k alone donnot put anything in it until you talk to some one about it I learned the hard way...

Now there is no income for me because of the 401k and a husband soon to be ex hubby who blew all the money in sight...

OK I wrote a blog along time ago explaining the reasons behind our 401K withdrawl last fall, so i won't repeat myself. I will say that when our taxes were all done this year, we did not have to write a check to the IRS as feared; we had enough misc farm and business deductions to just about break even, which i am thankful for. We still have the lion's share of 401k left in our Fund acct. that we manage ourselves as my husband's new workplace does not offer 401k yet. We used the cash to pay off our debt....because to not do so would eventually result in chargeoffs or worse yet bankruptcy, due to the lowered wages we have to deal with now. While I don't reccommend touching retirement savings, I will say it was a prudent move for us. We also had an emergency fund that was depleted by the time we decided to dip into the 401k. So we had done everything by the book, and were looking forward to having our debt gone within 3 months anyway....when life dealt us a blow. This is how i chose to deal back. I am fortunate the penalties and taxes were not as harsh as I'd been prepared for.

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About Gary

For more than 25 years, Gary Foreman has worked to manage money effectively. Prior to starting The Dollar Stretcher, he was a financial planner and purchasing manager.
While helping clients manage their hard earned money as a financial planner, he applied commonsense, time-tested techniques during the turbulent 1980’s. The experience convinced him that you didn’t need to hit the lottery to accumulate significant wealth.
Following that, Gary had an opportunity to learn more about how to get the best value for a dollar spent in the corporate world. As the Purchasing Manager for a computer manufacturer, he was responsible for supervising over $10 million in annual purchases.
Gary began The Dollar Stretcher website <www.TheDollarStretcher.com> and newsletters in April 1996. Over 300,000 readers benefit from the time and money saving ideas presented in The Dollar Stretcher newsletters each week. His mission is to help people "Live Better for Less".
He also provides private label newsletters for companies wishing to provide money saving information for their clients and/or prospects.
Gary lives in Florida along with his wife of thirty years and their two children. Much of his time is spent working with the men's ministry of his church. One of their ongoing projects is the "Holy Smoke BBQ" which sells bbq on Friday nights with the profits going to support local foster kids and orphans.
When he has a free moment you’ll find him restoring a Checker station wagon nicknamed “Two Ton” or cruising in a '65 Impala SS Convertible with doo-wops playing in the background.

Dollar Stretcher, Inc. does not assume responsibility for advice given. All advice should be weighed against your own abilities and circumstances and applied accordingly. It is up to the reader to determine if advice is safe and suitable for his or her own situation.